international trade and balance of payments for 2nd semester economics for BBA

International Trade and Balance of

payments

Chapter 10

International Trade and Balance of payments

“The benefit of international trade-a more efficient employment of the productive forces of the world.” (J.S. Mill)

Gains from international trade Whether trade liberalization promotes growth or hurts

it, there are debates on this. A number of anti-globalization activists and domestic industry protectionists argue that trade creates unemployment by displacing workers employed in the domestic industry, increases environmental pollution and degradation, and contributes to higher income inequality.

But the supporters of trade liberalization argue that it increases specialization, contributes to economies of scale, brings new ideas and innovation, makes domestic market competitive and ultimately contributes to growth and poverty reduction.

Gains from international trade In their paper “Trade, Growth and Poverty”, Dollar

and Kraay mention that globalizers countries that liberalized trade have grown at the higher rate than the non-globalizers, countries that didn’t liberalize trade. In the 1990s, the globalizing developing economies grew at 5% per capita more than double of such rate in the rich countries (2.2%) and more than triple of the non globalizing developing countries (1.4%).

According to Dollar and Kraay, the experiences of the post-1980 globalizers show that the process can have great benefits, contributing to rising incomes and falling poverty and enabling some of the poorest countries in the world to catch up with richer countries.

Gains from international trade

The real losers from globalization are those developing countries that have not been able to seize the opportunities to participate in this process. Thus, their idea seems that the integration of the world economy over the past twenty years has been dramatic and open trade regimes has led to faster growth and poverty reduction in poor countries


Economies of scale: Trade provides an opportunity to countries to specialize in certain products and reduce the unit costs with a larger output resulting in from increasing return to scales. But, protected markets not only have fragmented production internationally, they also create room for proliferation of too many firms in narrowly domestic markets. Because of this, the scale of production becomes inefficient.

Increased competition: Trade provides opportunities to domestic producers to be competitive, explore new ways of doing business and diversify trade in the global market.


Knowledge spillover and transfer of technology: Not only domestic producers but also the economy as a whole gain from the knowledge and technology transfer resulting in from the economic integration in the world market.

Increased efficiency or Elimination of deadweight loss: Trade provides opportunities to domestic producers to be competitive, explore new ways of doing business and diversify trade in the global market.


Good governance: Trade reduces the chance of corruption, rent seeking and unnecessary bureaucratic hurdles to entrepreneurs. It gives an opportunity to government to timely review its trade policy, modernize customs and other revenue mechanisms, and offer better services in the face of global competition.

Widens the market: the foreign trade integrates a country with other countries. Hence, the market for goods is widened. A country need not remain limited to own market.


Promotion of employment opportunities: The increase in foreign trade leads to the development of export-oriented industries. This promotes employment opportunities. Consequently, the income and standard of living of people increase.

Meaning of comparative advantage

The Comparative Cost Theory was first systematically formulated by the English economist David Ricardo in his "Principles of Political Economy and Taxation," published in 1817. It was later refined by J.S. Mill, Marshall, Taussig and others.

The Ricardian theory is based on the following assumptions:

1. Labour is the only element of cost of production.

2. Goods are exchanged against one another according to the relative amounts of labour embodied in them.


3. Labour is perfectly mobile within the country but perfectly immobile between countries.

4. Labour is homogeneous.

5. Production is subject to the law of constant returns.

6. International trade is free from all barriers.

7. There is no transportation cost.

8. There is full employment.

9. There is perfect competition.

10. There are only two countries and two commodities.

Meaning of comparative advantage Based on its simple assumptions, The Ricardian model is the simplest model that

shows how differences between countries give rise to trade and gains from trade. In this model labor is the only factor of production and countries differ only in the productivity of labor in different industries.

In the Ricardian model, countries export goods that their labor produces relatively efficiently and import goods that their labor produces relatively inefficiently. This means a country’s production pattern is determined by comparative advantage.


A country is said to have a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries.

Trade between two countries can benefit both if each country exports the goods in which it has a comparative advantage.


Apples Bananas

Home aLa=3 hrs for one apple

aLb=2 hrs for one banana

Foreign a*La=5 hrs for one apple

a*Lb= 1hr for one banana


Based on the information given in the above table, Opportunity cost of producing one apple for Home

=3/2=1.5 (i.e. 1 apple is equal to 1.5 banana) Opportunity cost of producing one apple for

Foreign=5/1=5 (i.e. 1 apple is equal to 5 banana for foreign)

Think which country has higher opportunity cost for producing apple, and which country will produce and export which product according to the comparative advantage theory.

Analyzing the case of comparative advantage

Suppose the home country has 1200 units of labor available. It can produce two goods: apples and bananas. The unit labor requirements for Home are 3 and 2 for apples and bananas respectively.

a) Graph Home’s PPF

b) What is the opportunity cost of apples in terms of bananas?

Home’s PPF

When there is only one factor of production, PPF will look like:


Given that it takes 3/2 as much time to make an apple as a banana, the opportunity cost must be: 3/2


Now, suppose the foreign country has 800 units of labor available. The unit labor requirements for Foreign are 5 and 1 for apples and bananas respectively.

a) Graph Foreign’s PPF

b) Show the Home and Foreign gains from trade on the PPF

Foreign’s PPF

After trade gain for Home

After trade gain for foreign

Main idea of Ricardian Model

Ricardian model is based on the notion of comparative advantage. This model recommends that a country should specialize in a good in which it has comparative advantage rather than absolute advantage. Thus, this model does a good job in predicting that countries will tend to export goods in which they have relatively higher productivity. This prediction of Ricardian model is confirmed by a number of studies as mentioned by Krugman and Obstfeld in “International Economics”.

Some drawbacks associated with the prediction

Despite the good prediction this model does, it makes misleading predictions in the following ways:

First, this model predicts an extreme degree of specialization that we do not observe in the real world. In the real world, countries do not confine in producing a single product. Extreme degree of specialization may not be practical because of the existence of more than one factor of production, because countries sometimes protect their industries from competition, and it is costly to transport goods and services.


This model assumes that countries as a whole will always gain from trade. But, in real life, there is a strong effect of international trade on income distribution. For example, with opening of trade certain section of the people who are engaged in some small and cottage industries may loose their job because of the displacement of such industry. And these labors may not be able to move freely since their skill may not match with the requirement of new industries. Even if they could move, their real wage may be less since they are new for the new industry. But the Ricardian model assumes that trade makes real wages to go up or remain same because of the free movement of labor without the loss of skill.


The model does not allow any role for differences in resources among countries. But the international trading system is largely driven, among others, by resource differences. A country with more resource endowment can have more influence in the global trade. The influence of OPEC countries is an example of this.

The model ignores the role of economies of scale as a cause of trade. Thus, the large trade flows between apparently similar nations is unexplained by Ricardian Model. When countries concentrate their resources in certain products, they also gain from the economies of scale.

Protectionism Meaning: The term protection refers to a policy whereby

domestic industries are to be protected from foreign competition. The aim is to impose restrictions on the imports of low-priced products in order to encourage domestic industries producing high priced products.

Protection takes in form of imposing import duties which raise the price of foreign goods by more than the price of domestic goods. Or, they may be protected by quotas or other non-tariff restrictions which make imports of cheap foreign goods difficult. Or, the domestic industries may be paid subsidies-or bounties to enable them to compete with cheap foreign goods.

Arguments for protectionism Terms of Trade Argument. The terms of trade

argument is given to correct disequilibrium in the balance of payments of a country. It is argued that the imposition of a tariff on imports improves the rate at which the country's exports are exchanged for imports. This means that a tariff improves its terms of trade because the foreign exporter is forced to pay some part of the import duty.

Bargaining Argument. It is argued that the imposition of tariffs is necessary to bargain in trade negotiations with other countries. Since international trade is based on reciprocal basis, tariff is used as a weapon to persuade or dissuade other countries to lower the tariff wall. Thus, the fear of tariffs may induce countries to give reciprocal concessions to each other.

Arguments for protectionism Anti Dumping Argument. Protection is

advocated against the practice of dumping. Dumping means selling a product in a foreign market at a lower price than in the home market, after taking into account transport and other costs of transfer. Dumping aims at flooding foreign market with-low-priced commodities. As a result, the import competing firms are ruined. To protect such firms, a high tariff is imposed. This will raise the price of the product in the importing country and remove the threat of dumping.

Arguments for protectionism Diversification Argument. Another

argument in support of protection is to diversify the domestic industries. It means that there should be a balanced growth of the economy so that all the sectors of the economy develop simultaneously. For this, agriculture and manufacturing industries should be protected from foreign competition. This is assumed to be valid argument particularly during the period of international economic disturbances, such as crop failures, depression, inflation, war, etc.

Arguments for protectionism Infant Industry Argument. The infant

industry argument is the oldest argument for protection. It was formulated by Alexander Hamilton in 1790 and was popularized by Friedrich List in 1885. This argument tests on the assumption that the country has a latent comparative advantage in the industry or group of industries to be protected. It is, therefore, argued that if industries in their infancy are not protected from established foreign producers, they cannot develop to enjoy the comparative advantage. For this, they must attain the optimum size so as to operate most efficiently and competitively.

Arguments for protectionism Socially Important or Key Industries Argument.

Protection should be given to socially important -industries such as agriculture or strategically important industries as iron and steel, heavy electrical, machine making, heavy chemicals, etc.

Employment Argument. A usual argument for protection is that it is a cure for unemployment. The imposition of a tariff reduces imports and encourages employment directly in import competing industries. This in turn, generates employment in other industries dependent upon this import-competing industry and may ever spread to import substitution industries.

Arguments for protectionism Balance of Trade Argument. The balance of

trade argument is based on the notion that a country should impose tariffs to have a surplus of exports over imports.

Pauper Labor Argument. It is argued that goods produced by workers getting high wages in one country cannot compete with goods produced by low-wage workers in the other country. Therefore, high wage domestic goods should be protected from low-wage imported goods by imposing tariffs.

Arguments for protectionism Defense Argument. A country should adopt

the policy of protecting its industries from the standpoint of national defense. If a country is dependent on other countries for its requirement of agricultural and industrial products, it will be very harmful for its national interest in times of war. The argument runs that it is no of use amassing wealth and becoming richer, if the country is not in a position to defend its freedom.

Arguments for protectionism Preservation Argument. Protection is advocated to

preserve the special ethos of the nation and certain classes of the population or certain occupations. It is argued that these would tend to disappear under free trade and there preservation is desired on political and social grounds. This argument is put forth to safeguard the interests of the agriculturists. The imposition of agricultural duties on the import of farm products is beneficial for the farmers who would be assured fair prices for their products. This is the reason for what US and European Union countries have protected their farmers with huge amount of subsidy.

Balance of payments (BOP) A through understanding of balance of payments

accounting helps in evaluating the implications of a country’s international transactions.

The trends and the existing position of the balance of international payments of a country significantly affect the economic policies of its government. As every country strives to maintain a favorable balance of payments, the trends and the existing position of the balance of payments significantly influence, in particular, the nature and types of regulation on export and import business.

Balance of payments A country’s balance of payments accounts

keep track of both its payments to and its receipts from foreigners. Any transaction resulting in a payments to foreigners is entered in the BOP accounts as a debit and is given a negative (-) sign. Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive (+) sign.

Balance of payments The IMF BOP Manual 5 defines balance of

payments as a “statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world.”

The basic convention applied in constructing the BOP is the double-entry accounting system. Every transaction is represented by two entries with equal values but opposite signs, a debit (-) and a credit (+).

Balance of payments By convention certain items are recorded as

debits and others as credit, as follows:

Export of goods and services Credit (+)

Import of goods and services Debit (-)

Increase in financial liabilities Credit (+)

Increase in financial assets Debit (-)

Decrease in liabilities Debit (-)

Decrease in assets Credit (+)

Balance of payments The BOP identity is shown in the following way:

A. Current account

B. Capital account

C. Financial account

D. Net errors and omissions

E. Reserves and related items

See the attached NRB sheet for detail

Balance of payments The BOP manual’s standard classification system has

three accounts: current account, capital account, and financial account.

Current account: The current account is comprised of goods, services, income, and current transfers.

Transactions classified under goods relate to the movement of merchandise and generally involve a change of ownership.

Services refer mostly to the transportation and insurance of merchandise shipments, transport fares paid by travelers, tourist services (hotels, restaurants), royalties and license fees, communications, constructions, house rentals, government purchases (in connection with embassies, for example), and other items.

Balance of payments Income may be derived from labor, and financial

assets and liabilities. Thus, there are mainly two items: compensation of employees, and investment income.

In compensation, earnings of Nepalese workers working abroad for less than one year is a credit item, and payments to foreign workers working in Nepal for less than one year is debit item.

Under investment income, credit entries reflect dividend and interest received by domestic owners of capital. For example, interest earned by NRB and commercial banks on their holdings of foreign government bills and securities.

Balance of payments Under investment income, debit entries reflect

dividend and interest received by foreign owners of capital. For example, dividend received by the foreign firms owning Bhotekoshi and Khimti, and also dividend received by the parent companies of Nepalese joint ventures.

Interest paid on foreign debt also comes under this item.

Balance of payments Another item under current account is current

transfers. These transfers are largely dependent on decisions made by governments of countries that are foreign aid donors. Thus, current transfers mainly include: grants and workers remittances. Current transfer grants include food aid, emergency and relief assistance and other grants which are not of investment nature. Workers remittance is the amount that people working abroad for more than one year have sent or the amount paid to foreign workers who are working in this country for more than one year.

Balance of payments Capital account consists of: (a) capital transfers, (b)

acquisition or disposal of non-financial assets. Capital transfer is the transfer of investment nature. Capital expenditure related assistance by the foreigners or to the foreigners. Migrants’ income or transfer for example British Armies’ selling properties and transferring wealth to the UK is also capital transfer. It may be in cash or kind. Debt forgiveness is also included under this.

Financial account has four functional categories: (a) direct investment, which is further divided into equity capital, and reinvested earnings, (b) portfolio investment, which includes long term debt and equity securities, money market instruments, and tradable financial derivatives, including currency and interest rate swaps.

Balance of payments Financial account has four functional

categories: (c) Other investment such as trade credits and general borrowing and IMF credit, and (d) reserve assets, available to meet immediate needs to make foreign payments.

Net errors and omissions are unidentified and missing amounts of different headings.

Reserve assets include foreign exchange (currency, deposits, and securities), monetary gold, SDRs, and country’s reserve position in the IMF.

Overall BOP is the change in the net foreign assets of the banking sector.

Balance of paymentsCauses of disequilibrium: Development schemes: for industrialization, country may

need to import more, export may fall. Price cost structures: Increase in prices because of

higher wages, and higher cost of raw materials etc reduce exports and makes the BOP unfavorable.

Changes in foreign exchange rate: Appreciation of domestic currency may induce import and cause BOP balance deteriorate.

Fall in export demand: Because of the cheap products produced within country or imported from other countries may cause a fall in export demand.

Demonstration effect: countries of poor countries may also change their consumption habit and follow those of the developed countries leads to high import demand.

Balance of paymentsCauses of disequilibrium: Cyclical fluctuations: During depression,

foreigners may demand less since their income has fallen. This may cause disequilibrium on BOP.

Population growth: Rapid growth of population cause high import and BOP disequilibrium.

Natural factors: Natural calamities such as droughts, floods, cause low production and high import. This also causes BOP disequilibrium.

Balance of paymentsMethods of correcting BOP disequilibrium: Deflation: Adopting contractionary monetary policy. This

causes lower price and low monetary income. The idea is this causes export promotion through price reduction and reduction in import through income decline at home.

Currency devaluation: This is done to make import dearer and export cheaper.

Exchange control: All exporters are asked to surrender foreign currency at central bank and central bank rations the currency among license holders.

Capital movement: Raising domestic interest rate can cause capital inflow.

Encouraging exports: Through duty reduction, subsidy, negotiations with trading partners for favorable trade conditions.

Discouraging imports: Through import quotas, import duties, import substitution policies.

Foreign direct investment

Foreign finance: in addition to the foreign aid, it can be in the form of private foreign direct and portfolio investment.

Private direct investment, commonly known as FDI is made by large multinational corporations (e.g. General Motors, USA; Ford Motor, USA; Toyota Motor, Japan; Daimler Benz, Germany) with headquarters in the developed nations.

Foreign portfolio investment (e.g. stocks, bonds, and notes) in LDC “emerging” credit and equity markets by private institutions (banks, mutual funds, corporations) and individuals.


Why do countries need foreign finance? To meet the saving investment gap (Recall the

Harrod-Domar model g=s/k). If a country needs to grow at the rate of 10% at a “k” of 3, the required saving investment would be 30%. And if the domestic saving is only 14%, the country needs to meet this gap of 16% through foreign finance.

To meet the foreign exchange gap. Forex gap is the difference between the required foreign reserve and the net export earnings plus net public foreign aid.


Why do countries need foreign finance? The third gap it can meet between targeted

governmental tax revenues and locally raised taxes. Raising tax from MNCs, developing countries’ government would be in better position to utilize resources.

Another can be in reducing the gap in technological knowledge, managerial expertise and entrepreneurial skills. Transfers of knowledge, skills, and technology are both desirable and productive for the recipient countries.


What are the counter arguments? May lower domestic savings and investments

by stifling competition through exclusive production agreement with host governments, failing to reinvest much of their profits, generating domestic incomes for groups with lower saving propensities, and inhibiting the expansion of indigenous industries that would supply materials and intermediate goods.


What are the counter arguments? Despite the short term accumulation of forex

reserve, in the long run both current account and capital account may deteriorate. Current account will deteriorate because of the imports of capital goods and intermediate goods and capital account because of the overseas repatriation of profits, interest, royalties, management fees and other funds.


What are the counter arguments? Even though there are some contributions of

MNCs to tax revenue, it can be lower than what it should be because of the liberal tax concessions, excessive investment allowances, tariff protection by the host government.

It may inhibit the growth of local entrepreneurship since the local market is dominated by MNCs.


Some more fundamental objections: MNCs only cater to the needs of local elites.

Production, job opportunities, and location all are in favor of rich people. They don’t produce goods like food for mass consumption rather produce sophisticated goods for rich people. They are located in urban centers and increase the rural-urban gap. .


Some more fundamental objections: MNCs produce inappropriate products (demanded

by local elites, small fraction of population) and convert local tastes and preferences into exotic ones.

Create more capital-intensive processes, thus replacing labor and causing increased unemployment problem.

MNCs may damage host economies by suppressing domestic entrepreneurship and using their superior knowledge, worldwide contacts, advertising skills.


Some more fundamental objections: At the political level, MNCs gradually gain control

over local assets and jobs and then build influence on host country government/political forces and decision-making. They can do this also by joining hands with corrupt officials at high levels through corruptive means and promoting rent seeking cultures.

international trade and balance of payments for 2nd semester economics for BBA

Education

Transcript of international trade and balance of payments for 2nd semester economics for BBA